Simon Wren Lewis on central bank independence

Simon is a member of Jeremy Corbyn’s economic advisory team, and participating in a review commissioned by John McDonnell on the Bank of England’s mandate.

So the fact that he sees fit to pose the question ‘can central banks make 3 major mistakes in a row and stay independent’ is significant.   That is, you are interested in forming a view about what kind of economic platform Labour will run on if Corbyn survives in post as Labour leader until the 2020 election.

It’s clear that Simon thinks the case for central bank independence is for many, moot, though he himself is in favour.

He writes:  ‘I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this.’  We are left presuming that these ‘non-economists’ are those whose team he joined in Corbyn’s Labour Party.

Simon’s blog has the Bank of England charged with making 3 ‘mistakes’, the corollary of which is that perhaps the central bank should no longer be independent.

I don’t think Simon makes a case that is at all persuasive.

In short, as I tweeted earlier, I think that it’s highly contestable whether the mistakes Simon identifies were indeed mistakes.  And even if they were, it does not follow that central banks should have their independence curtailed.

Independence was introduced to shield monetary and financial policy the pressures of short-run electoral expediency.  Removing independence removes this shield, for no gain in terms of avoiding future ‘mistakes’.

Mistake 1 is that the Bank of England failed to foresee the financial crisis.  There is certainly truth to this, though the Bank is wont to point to repeated warnings in BoE-ease in its Quarterly Bulletins, and other vehicles, in the run-up to 2008.

But, taking this lack of foresight to be true, most of the economics profession failed in the same way.  One or two notables (my favourite being Rajan’s Jackson Hole speech) did not, and made intelligible, reasoned and prescient interventions.  Many of those who, ex post, look like they saw it all coming, did not, and as Noah Smith and others have commented, can be dismissed.

In the UK, we can take it that the bulk of the UK establishment, including the Treasury, likewise failed to foresee what was happening, because they did not intervene to alter the regulatory stance and framework in the way that was begun once the failings became known.  So, if we had run a counterfactual history in which the Bank of England had simply enacted whatever the Treasury had asked for, I don’t see that the instrument settings, or the legislation, would have turned out any different.

Are there memos lurking somewhere in which past Chancellors were urging higher interest rates or more punitive regulatory stances?  I doubt it.  [Note that anyway I would suggest that it would have been damaging and futile to try to head off the financial crisis with tighter monetary policy].

Mistake 2 was that the Bank of England did not protest sufficiently about the tightness of fiscal policy imposed by the Coalition government post May 2010.

Assume for a moment that the BoE should have protested.  Do we think that a monetary policy body that was not independent would do any better?  The Coalition did what they did because they thought it was the right or expedient thing to do.  Would they have been swayed by private advice by civil servants?  Would that advice be any more likely to be forthcoming?  I doubt it.  So it does not follow, in my view that mistake 2 is a case against independence.

However, I think it’s contestable whether there was a mistake at all.

I take the view that, initially, Coalition fiscal policy [at least its aggregate stance] was perfectly reasonable, until it had become clear that the UK was not to be put in the same basket as the other troubled sovereigns.  Subsequently, on risk management grounds, looser policy might have been preferable, but not [ex ante] to generate higher demand, but to provide for tighter monetary policy which could have allowed for future cuts if needed.  The large and protracted undershoot of the inflation target subsequently looks like a bad mistake, but, ex ante, the case – made by the BoE – that this was largely due to surprises about the extent and persistence of the pass through of Sterling, and weak commodity prices, seems fair enough to me.

Further, even if the Bank had disapproved of Coalition fiscal policy, speaking out against it could have undermined the efficacy of monetary policy in the future.  Without a specific commission to do so in its mandate, there would be the risk that future MPC members would be selected for their favourable stance toward the Government in general.

What might follow, if you accept that there was a mistake number 2, is that the mandate should be amended to provide for explicit comments from it on whether its ability to meet the inflation target was being hampered by government fiscal policy.

Mistake number 3 is that the Bank of England has been too pessimistic about the supply side of the economy, setting correspondingly too-tight monetary policy.  I have dealt with this partly in my response to mistake number 2.  But a few more remarks.

First, the 0.5 floor was not set, initially, as a matter of monetary policy conservatism, but because it was judged that cutting rates below that floor would not be stimulative [because of the difficulties it would cause for bank balance sheets].  This view about the floor to rates was amended back in March 2015.  So the charge that this floor signifies conservatism applies only since then.

Second, there is the implication that the BoE did not apprehend that potential output was itself a function of the level of demand, and thus its own policy stance.  In fact, it did, right from the off, during the crisis, and this possibility – it surely has to remain just that – was mentioned frequently in its communications, and discussed at length in private.

Third, would rolling back independence cure monetary policy of ‘supply-side pessimism’?  I doubt it.  If it did, would we get better policy?  Or would we get an optimism/pessimism that was a function of the electoral cycle?  Simon clearly wants looser policy now, and so a bit more supply side optimism would do it for him.  But would that be helpful in a few years, when monetary policy is no longer at risk of being constrained?

Simon’s mistake number 3 actually contains what I would classify as a separate mistake number 4, the failure to appreciate that, in the vicinity of the zero bound, the best way to hit the inflation target, on average, is to contemplate and engineer an overshoot.  I think Simon is largely right on this.  There are dissenting voices in the Fed – notably Charles Evans.  But none in the BoE’s MPC.  I don’t think it follows that rolling back central bank independence is a good idea.  Since many economists dispute that the overshooting policy would be a good idea, one presumably would have monetary policy informed by the same spread of views inside the Treasury, or a subservient BoE.  At the zero bound, one could reap the benefits of ‘boom=good’ that would occur to the politicians, but away from it, this would be harmful.  Much better to clarify what’s anticipated in the mandate, at the zero bound.  And not to reappoint those who take what you think is the wrong view of the matter.

All this said, I do think it’s fair enough to debate the merits of independence.  Given the huge and varied powers now vested in the Bank, and the intractability of the problem of providing it with adequate formal scrutiny, one should probably err on the side of over-debating it.

For that reason, even though I am not convinced by Simon’s arguments, it’s to be welcomed that they are out there.

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